FASB, Investors, and Disclosure

A retail company begins operations late in 2000 by purchasing $600,000 of merchandise. There are no sales in 2000. During 2001 additional merchandise of $3,000,000 is purchased. Operating expenses (excluding management bonuses) are $400,000, and sales are $6,000,000. The management compensation agreement provides for incentive bonuses totaling 1% of after-tax income (before bonuses). Taxes are 25%, and accounting a taxable income will be the same.

The company is undecided about the selection of the LIFO or FIFOinventory methods. For the year ended 2001, ending inventory would be $700,000 and $1,000,000 respectively under LIFO and FIFO.

Required:

How are accounting numbers used to monitor this agency contract between owners and managers?
Evaluate management's incentives to choose FIFO.
Evaluate management's incentives to choose LIFO.
Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth?
Why is the management compensation agreement potentially counter-productive as an agency-monitoring mechanism?
Devise an alternative bonus system to avoid the problem in the existing plan.

Solution Preview

1. How are accounting numbers used to monitor this agency contract between owners and managers?
a. (How this question is to be answered) This question is subjective - based on your knowledge of accounting. Please support your answer.
There is a relationship of agency between the owners and managers. Let us understand this relationship, an agent is a person who does any act for another or represents another in dealing with third persons. The person for whom such act or representation is done is called principal.

Thus there are two essentials of the relationship of the agency:
1. Agreement between principal and agent
2. Intention of the agent to act on behalf of the principal.

Duties of the Principal towards agent
1. To indemnify the agent against the consequences of all lawful acts and acts done in good faith.
2. To make payment to the agent the commission or remuneration as per the agreement
3. To indemnify the agent for injury caused by the principal's neglect

Duties of Agents towards Principal
The Agent's primary fiduciary duty is to be loyal to the Principal. This involves duties:
not to accept any new obligations those are inconsistent with the duties owed to the Principal.

1. To do the work according to the directions given by the principal
2. To carry out the work with reasonable care, skill and diligence.
3. To maintain and submit proper accounts to his principal
4. Not to do any work on his account and not to use information obtained in the course of agency against the principal.
5. Not to make any secret profit
6. Not to delegate authority
7. To pay sum received for the principal

(Kapoor, N.D.)
Thus accounting numbers can be used to monitor this relationship by the way of compensation ...

Solution Summary

Over a thousand words to explain how one can monitor a contract via accounting, along with an evaluation of FIFO and LIFO and policy suggestions on security prices.